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The U.S. Federal Reserve Board charts an independent course in the supervision of foreign banking organizations

The Board of Governors of the Federal Reserve System (“Board”) in December 2012 issued a proposed rule under the Dodd-Frank Act (“DFA”) for the enhanced supervision of foreign banking organizations (“FBOs”) and any foreign nonbanking financial companies that may be designated as systematically important financial institutions (“SIFIs”). The proposed rule in large part followed the substantive provisions of the Board’s earlier proposal for the enhanced supervision of large domestic bank holding companies (“BHCs”) and domestic SIFIs. See DechertOnPoint,Potential SIFIs Take Note—Your Future is Being Decided Now; FRB Prepares to Act on Enhanced Prudential Supervision.

The FBO proposal is a marked departure from how the Board has supervised the U.S. operations of FBOs in the past. It would require large FBOs with $10 billion or more of assets in U.S.-chartered subsidiaries and all foreign SIFIs to place all their U.S. operations, other than the branches and agencies of a foreign bank, in a U.S.-based intermediate holding company (“IHC”) and would impose enhanced capital, liquidity and other prudential requirements on those IHCs, separate from and in addition to the requirements of the parent company’s home country supervisor. See DechertOnPoint, U.S. Federal Reserve Board Proposes Major Changes in How the U.S. Operations of Foreign Banks and their Subsidiaries Are Supervised. As discussed below, these measures and the other provisions of the proposed rule would have significant consequences for the entities affected and for U.S. financial markets.

The comment period on the proposed rule closed on April 30, 2013. As expected, a large majority of commenters opposed it. This article summarizes the requirements of the proposed rule, the Board’s reasoning behind it and the responses of commenters.

The IHC Structure and New Supervisory Requirements

Pursuant to sections 165 and 166 of the DFA, the proposed rule would apply to all FBOs with global total consolidated assets of $50 billion or more (“Large FBOs”) and all foreign SIFIs. The proposal also would impose certain requirements on smaller FBOs with global total consolidated assets of as little as $10 billion. In general, the larger an FBO or foreign SIFI and the larger its U.S. operations, the more extensive the prudential requirements that would be imposed.

Intermediate Holding Companies

A Large FBO with total consolidated assets of $10 billion or more in its U.S.-based subsidiaries (i.e., excluding assets of its U.S. branches and agencies) would be required to establish a U.S.-based IHC for all of its U.S. banking and nonbanking operations that are not housed in its U.S. branches and agencies, in order to provide a platform to the Board for more extensive prudential supervision of its U.S. operations. All foreign SIFIs would be required to establish an IHC for all their U.S.-based subsidiaries. An IHC would be subject to the same risk-based capital and leverage capital requirements as apply to BHCs, regardless of whether the IHC actually controlled a bank. Liquidity, single counterparty credit limit, risk management, stress test, debt-to-equity limit and early remediation requirements also would apply. Some requirements would apply to all U.S. operations (i.e., including both subsidiaries and any branch and agency network), while others would apply only to U.S. subsidiaries.

Under current Board policy, a U.S. BHC that is owned and controlled by an FBO that is qualified as a financial holding company generally is not required to comply with the Board’s capital adequacy guidelines, if the Board has determined that the FBO is well capitalized and well managed. In those cases, the Board relies on the capital strength of the consolidated banking organization. Section 171 of the DFA overrides this policy, effective July 21, 2015. In anticipation of that change, a few FBOs have reorganized their U.S. operations to eliminate their BHC subsidiaries, thereby seeking to avoid capital requirements at the U.S. holding company level. The proposed rule would eliminate this option for Large FBOs by requiring them to establish IHCs to house their U.S. banking and nonbanking subsidiaries.

An IHC would be the parent company entity for all U.S.-based functionally regulated subsidiaries of a Large FBO or foreign SIFI, such as broker-dealers and investment advisers registered with the Securities and Exchange Commission (“SEC”), commodity pool operators registered with the Commodity Futures Trading Commission and insurance companies regulated by state insurance commissioners, as well as for any bank or thrift subsidiaries of a Large FBO. Assets under management by a U.S.-based investment adviser subsidiary generally would not be included as part of the combined U.S. assets of an FBO or foreign SIFI to the extent those assets were not reflected on the balance sheet of the investment adviser.

Risk-Based Capital and Leverage Capital

A Large FBO would be required to certify to the Board that it meets capital adequacy standards that are established by its home country supervisor and are consistent with standards recommended by the Basel Committee on Banking Supervision (“BCBS”). A Large FBO also would be required to report its risk-based capital ratios to the Board. If a Large FBO did not satisfy these requirements, the Board could impose conditions or restrictions on its U.S. operations. A Large FBO’s U.S. branch and agency network would not be subject to any separate capital requirements.

An IHC would be subject to the same risk-based capital and leverage capital standards that apply to BHCs, regardless of whether the IHC controlled a bank. For IHCs with $50 billion or more of total consolidated assets, these standards would include the capital planning requirements set forth in the Board’s Regulation Y. An IHC would be prohibited from making capital distributions unless a satisfactory capital plan was submitted to and accepted by the Board.

Liquidity Requirements

A Large FBO or foreign SIFI with combined U.S. assets (i.e., including assets in any U.S. branches or agencies) of $50 billion or more would be required to meet enhanced liquidity requirements, including liquidity risk management standards, liquidity stress testing, the maintenance of a 30-day liquidity buffer consisting of highly liquid assets and the establishment of a contingency funding plan. These requirements would apply separately to an IHC and to any U.S. branch and agency network. For an IHC, all assets in the liquidity buffer must be held in the United States. For a branch and agency network, assets sufficient to meet the first 14 days’ liquidity requirements must be held in the United States.

A Large FBO or foreign SIFI with combined U.S. assets of less than $50 billion would be required to conduct an internal liquidity stress test, either on a consolidated basis or for its U.S. operations separately, and to report the results to the Board on an annual basis.

Single Counterparty Credit Limits

The single counterparty credit limits would apply to the combined U.S. operations of a Large FBO and separately to its IHC and the IHC's subsidiaries. The proposed rule describes the types of transactions subject to the limits and the methods for measuring gross credit exposures and net credit exposures arising from such transactions. Exposure to the U.S. federal government, federal agencies or Fannie Mae or Freddie Mac while in conservatorship would be exempt from the credit limits. Exposure to the home country sovereign of a Large FBO also would be exempt, but exposure to other foreign sovereigns would be subject to the credit limits.

The combined U.S. operations of a Large FBO or foreign SIFI would be subject to a limit on its aggregate net credit exposure to a single unaffiliated counterparty equal to 25% of the global organization’s consolidated capital stock and surplus. The combined U.S. operations of an FBO with $500 billion or more of global total consolidated assets (“Very Large FBO”) would be subject to a more stringent limit on its aggregate net credit exposure to an unaffiliated counterparty of similar size, such as another Very Large FBO or a BHC with $500 billion or more of total consolidated assets, or any SIFI.

An IHC would be subject to a limit on its aggregate net credit exposure to a single unaffiliated counterparty equal to 25% of the IHC’s consolidated capital stock and surplus. An IHC with $500 billion or more of total consolidated assets would be subject to the more stringent limits described above.

Risk Management

Risk management requirements would be comparable to those proposed by the Board for large BHCs and SIFIs. All Large FBOs and publicly traded FBOs with total consolidated assets of more than $10 billion would be required to certify to the Board on an annual basis that they maintain a U.S. risk committee to oversee the risk management practices of their combined U.S. operations. A Large FBO or foreign SIFI with $50 billion or more of combined U.S. assets would also be required to have a qualified U.S. chief risk officer.

Capital Stress Tests

The proposal would impose separate stress testing requirements on FBOs and foreign SIFIs and on their IHCs. Asset maintenance requirements would be imposed on the branch and agency network of an FBO that failed to satisfy stress testing requirements.

A Large FBO with combined U.S. assets of $50 billion or more would be required to submit to an annual capital stress testing regime administered by its home country supervisor that was broadly consistent with the Board’s stress testing regime for BHCs. If the U.S. branch and agency network of a Large FBO, on a net basis, provided funding to its non-U.S. offices and non-U.S. affiliates, then the Large FBO would be required to provide additional information to the Board regarding its annual home country capital stress test. If a Large FBO did not satisfy its home country requirements, then its U.S. branches and agencies would be required to maintain eligible assets on their books equal to not less than 108% of their liabilities and could also be required to maintain a liquidity buffer.

An FBO with combined U.S. assets from $10 billion to $50 billion also would be required to submit to an annual capital stress testing regime administered by its home country supervisor. If an FBO did not satisfy these requirements, its U.S. branches and agencies would be required to maintain eligible assets on their books equal to not less than 105% of their liabilities.

An IHC would be subject to the same capital stress test requirements as apply to a BHC. All IHCs would be required to conduct an annual “company-run” capital stress test in accordance with baseline and stressed economic scenarios established by the Board. IHCs with $50 billion or more of total consolidated assets also would be subject to an annual “supervisory” capital stress test conducted by the Board and would be required to conduct a mid-year “company-run” capital stress test based on baseline and stressed economic scenarios established by the IHC.

Debt-to-Equity Limits

If the Financial Stability Oversight Council were to determine that a Large FBO or foreign SIFI posed a “grave threat” to the financial stability of the United States, its IHC would be required to maintain a debt-to-equity ratio of not more than 15-to-1, and the Large FBO’s U.S. branch and agency network would be required to meet a 108% asset maintenance requirement.

Early Remediation

The combined U.S. operations of Large FBOs and foreign SIFIs would be subject to a four-level remediation regime. Remediation would be triggered if an IHC or its parent organization evidenced financial weakness based on the regulatory capital, capital stress test, liquidity management or risk management requirements described above or certain market indicators to be established in future rulemaking.

A Large FBO or foreign SIFI with $50 billion or more of combined U.S. assets would be subject to mandatory remedial actions applicable to its IHC, U.S. branch and agency network, combined U.S. operations and the FBO or foreign SIFI itself. Remediation measures would increase in stringency (from Level 1 to Level 4) based on the degree of noncompliance with the applicable prudential requirements. Remedial actions would include, among other things, dividend limitations on the IHC, intercompany funding limitations on the U.S. branch and agency network, limitations on asset growth and business expansion in the United States, limitations on executive compensation and, ultimately, termination or resolution of the combined U.S. operations.

For Large FBOs and foreign SIFIs with less than $50 billion of combined U.S. assets, the remediation actions described above would not be mandatory, but would be applied on a case-by-case basis in the discretion of the Board.

The Board’s Concerns: Different Times Require Different Measures

The proposed rule would re-orient the Board’s supervision of FBOs and any foreign SIFIs from an international model, in which it is presumed that the cross-border operations of large and internationally active financial institutions can be successfully supervised based on the mutual interests of and cooperation among banking supervisory authorities in multiple jurisdictions, to a U.S.-centric model.

In the preamble to the proposal, the Board recounted several lessons learned during and after the financial crisis regarding FBO operations in the United States. The Board noted that the business model of FBOs has shifted from an emphasis on traditional lending to one of serving primarily as a source of funding. As a result, FBOs have become net borrowers of U.S. dollars, often for short maturities and for the purpose of financing long-term dollar-denominated assets abroad. While these capital flows can promote efficiency and economic expansion during good times, the capital raised in the United States tends to become “trapped” in an FBO’s home country during a liquidity crisis. According to the Board, this exacerbated local liquidity issues for the U.S. operations of FBOs during the financial crisis and required the Board to extend substantial support to their U.S. branches and agencies and U.S. broker-dealer subsidiaries.

This experience has caused the Board to question the effectiveness of its current supervisory approach, which relies on the willingness and the ability of an FBO to act as a source of strength to its U.S. operations. In addition, the Board stated that it was required by the DFA to change its supervisory approach in certain respects, such as with regard to capital rules under Section 171, as discussed above. Thus, the Board has attempted in the proposed rules (i) to require FBOs to maintain substantially more capital and liquidity within the United States on a stand-alone basis to support their U.S. operations, (ii) to require FBOs to provide the Board with a stronger institutional platform for supervision through the establishment of an IHC and (iii) generally to supervise FBOs more intensively.

Commenters’ Concerns: Economic Harm and Unintended Consequences

Many commenters noted that the proposal may be harmful not only to FBOs and foreign SIFIs, but to BHCs and the interests of the United States as well. These comments may be grouped into seven broad categories: ring-fencing; consolidated home country supervision; national treatment; cross-border recovery and resolution; extra-territoriality; duplication, cost and inconsistency; and harm to U.S. financial markets.

Ring-Fencing

All IHCs would be subject to the Board’s regulatory requirements applicable to BHCs, even those IHCs that did not own a U.S. bank or thrift. The capital and liquidity that an IHC would be required to maintain in order to satisfy the Board’s requirements would not be available for use in other jurisdictions and would be effectively trapped in the United States. According to commenters, in a sharp departure from longstanding Board policy, this would deny to FBOs and foreign SIFIs the flexibility to determine the best corporate structure for their U.S. operations and the optimal use of capital and liquidity on a global basis. It also would mean, in times of financial stress, that the ability of an FBO or foreign SIFI to redirect capital in the United States to the foreign parent or to operations outside the United States or to provide liquidity would be limited.

As a result, commenters asserted that private participants in capital markets may be less willing to provide capital to the parent organization or to a troubled subsidiary outside the United States, which could reduce confidence in the organization as a whole, reduce the ability of an organization to recover without governmental assistance and increase systemic instability. Similarly, the inability of FBOs and foreign SIFIs to take decisive cross-border action to bolster the liquidity of a troubled subsidiary could increase reliance on central banks as lenders of last resort within each jurisdiction. According to commenters, the proposed rule signals the Board’s doubts that FBOs and foreign central banks can be relied on to provide adequate support to a troubled U.S. branch or subsidiary during a financial crisis, and would be likely to be followed by reciprocal protectionist action in other jurisdictions. This would expose BHCs and domestic SIFIs with operations abroad to the same harm from ring-fencing as described above.

Consolidated Home Country Supervision

The DFA requires the Board to “take into account the extent to which the foreign financial company is subject on a consolidated basis to home country standards that are comparable to those applied to financial companies in the United States” when setting enhanced prudential standards. Commenters asserted that the proposed prudential requirements for IHCs ignore this requirement, as well as the steps taken in some foreign jurisdictions that meet or exceed proposed U.S. requirements and the progress of international bodies in laying the groundwork for broad international compliance with comparable standards. Some commenters asserted that a better approach would be to set standards for effective comparable supervision by other countries and to defer to such supervision when the effectiveness of foreign supervision is demonstrated. Indeed, Secretary of the Treasury Jacob Lew, before the Senate Committee on Banking, Housing, and Urban Affairs on May 21, 2013, called for such an approach in order to encourage an international “race to the top.”

National Treatment

While a BHC is able to call on the capital and liquidity of its foreign subsidiaries in order to meet capital and liquidity requirements on a consolidated basis, an IHC would be required to satisfy the identical standards on a stand-alone basis. According to commenters, these requirements, while facially neutral, would be discriminatory as applied to FBOs. This would be contrary to the provisions of the International Banking Act and the express requirement of the DFA to “give due regard to the principle of national treatment and equality of competitive opportunity” when setting enhanced prudential standards for FBOs and foreign SIFIs. Commenters noted that the disparity would be particularly stark when the principal asset of an IHC was a U.S. broker-dealer subsidiary. The capital requirements for the IHC would be in addition to the net capital rules of the SEC for broker-dealers and could require in effect that a broker-dealer subsidiary of an FBO operate with substantially higher capital requirements than its U.S.-controlled peers. This result would also be inconsistent with the Bank Holding Company Act, which prohibits the Board from imposing rules, guidelines, standards or requirements on a functionally regulated subsidiary of a BHC. In addition, commenters noted that the requirement that an FBO maintain separate liquidity buffers for its IHC and for its U.S. branches and agencies would be more restrictive than the consolidated liquidity buffer that the Board has proposed to apply to large BHCs.

Cross-Border Recovery and Resolution

As the Federal Deposit Insurance Corporation and the Bank of England observed in their 2012 joint paper on resolving SIFIs, the “single point of entry” and “bail-in” approach to orderly resolution relies fundamentally on a host country not taking action to ring-fence the operations of a failed foreign bank within its borders. Rather, it calls on host country regulators to rely on home country regulators to provide the necessary flow of capital and liquidity to support local operations. According to commenters, this level of international coordination and cooperation would be undercut by the ring-fencing aspects of the proposal and the likely reciprocal steps that would be taken in other jurisdictions, as discussed above. Indeed, home country supervisors may conclude on the basis of the U.S. proposal that the Board has required all the capital and liquidity needed for the recovery or resolution of a failing FBO’s U.S. operations, and they may provide or permit less support for the U.S. operations than they otherwise would.

Extra-Territoriality

Included among the Board’s proposed standards for triggering the early remediation of an IHC is a decline in the capital of the parent FBO on a consolidated basis, even though the parent FBO may remain above the minimum capital requirements of its home country supervisor. Thus, commenters asserted that the Board could initiate substantial remediation requirements, which may be destabilizing for the parent FBO, apart from, or even in conflict with, the decision of an FBO’s home country supervisor regarding the advisability of such action on a consolidated basis.

Duplication, Cost and Inconsistency

An FBO or foreign SIFI may be required to incur substantial costs and to make significant efforts to reorganize its U.S. banking and nonbanking subsidiaries under an IHC structure. Thereafter, an IHC and its subsidiaries would be subject to all the capital requirements and reporting and compliance obligations applicable to BHCs in addition to any requirements imposed by the FBO’s or foreign SIFI’s home country supervisor. For some institutions, such as an FBO applying an advanced approach to modeling capital requirements under the BSBC capital accords but subject to the standardized approach under U.S. law, the cost of developing new systems and hiring additional personnel to achieve substantially similar outcomes may be considerable. Commenters asserted that the additional requirements also are inconsistent with the provision of the DFA, discussed above, requiring the Board to take into account an FBO’s home country supervision when imposing enhanced prudential standards.

Harm to U.S. Financial Markets

Commenters asserted that the increased costs for an FBO or foreign SIFI to operate in the United States as a result of the proposed rule may cause some organizations to decide not to commit additional resources to U.S. markets or to reduce their U.S. presence or withdraw entirely from the United States. This would increase concentration in the affected U.S. financial markets, increase interconnectedness among the largest participants in those markets and reduce financial stability. It also would result in reduced competition, reduced availability of financial products and services and increased costs. These effects would be mirrored in other jurisdictions that may follow the U.S. example. As a result, commenters asserted that U.S. and global economic growth may be reduced, internationally active financial institutions may be required to hold significantly more capital than intended or desired under the BSBC capital accords and the negotiation by the United States of expanded free trade agreements may become more complicated.

Conclusion

The proposal reflects the wide gulf in perception between the Board and its critics with respect to the appropriate regulation of international financial institutions. Commenters have asserted many potentially harmful effects of the Board’s proposed rules, ranging from the costs to individual organizations operating in the United States to the potential harm to financial markets and free trade negotiations. On the other hand, the Board has primarily focused on the burden placed on U.S. taxpayers and the United States government by the unraveling of financial markets during the recent financial crisis, including the support provided to the U.S. operations of FBOs. It remains to be seen how the Board will address commenters’ concerns and the extent to which it is willing to establish a new regime for the regulation of the U.S. operations of FBOs that departs significantly from the existing regulatory framework.

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